With investors on the run, bulls may charge back
The economic prognosis is relentlessly bleak.
Jobless numbers are soaring. Stocks are plunging. Your co-workers, your fellow passengers on the commuter train and even your dental hygienist are all volunteering that they’ve converted their 401(k) stock funds to cash.
Could it mean a bull market is just around the corner?
Economists and market strategists willing to call a bottom amid the current market turmoil are thin on the ground, vastly outnumbered by forecasters with distinctly more apocalyptic outlooks.
Yet with the Dow Jones industrial average trading at 34.6% below the all-time peak of 14,164.53 it reached exactly one year ago today, there are signs that conditions are in place for a sharp reversal of sentiment, some analysts say.
For evidence, they cite rock-bottom interest rates, tumbling prices of oil and other commodities and, not least, concerted efforts by central bankers to get the global economy back in gear.
“These are the moments that people look back on and say, ‘Man, if I only bought then!’ ” said economist Zachary Karabell, founder of River- Twice Research. “And nobody ever does.”
One glimmer of hope came in Wednesday’s coordinated rate cut by central banks in the United States and Europe. Many take the action as a signal that international economic regulators are determined not to repeat the mistakes of the 1930s, when central banks did just the opposite, tightening credit despite an economic slowdown. Further rate cuts may be in the offing.
In the U.S., rates already are approaching historic lows. Wednesday’s action by the Federal Reserve will drive the prime lending rate to 4.5%, its lowest level in four years and less than half the rate seen during much of the grinding bear market of 1973-74. That will make it cheaper for many people to buy big-ticket items such as cars and furniture on credit.
Then there’s the bailout. Governments worldwide are pumping trillions of dollars into their banking systems, including the U.S. mortgage rescue plan of up to $700 billion.
Many national governments are promising to insure all bank deposits and other bank liabilities, and the U.S. could soon follow suit. Central bankers are finding new and creative ways to keep their systems afloat, with the Fed preparing to lend against collateral it would not have accepted two years ago -- or even against no collateral.
Another positive indicator for a turnaround is the falling prices of oil and other essential commodities. Although this stems partly from expectations for a global economic slowdown, the trend does make it cheaper for businesses to produce and deliver goods, and it puts more money in the pockets of consumers.
Some might even see a positive note in the presidential race, in which Democratic Sen. Barack Obama currently leads Republican Sen. John McCain in opinion polls.
A 2006 study by Jeremy Siegel, a professor of finance at the Wharton School of the University of Pennsylvania, showed that from 1948 through February 2006, annualized stock market returns averaged 15.3% under Democratic administrations and 9.5% under Republicans.
Had the study been updated to reflect the market’s performance since then under President George W. Bush, the discrepancy would have been larger. During that period, the Standard & Poor’s 500 index has fallen 23.7%.
One big wild card is emotion. Many of the recent government rescue initiatives attempt to address this fuzzy but fundamental element of the capital markets.
In recent weeks the credit and equity markets have been gripped by fears that, in specific cases, one’s trading partner may not be able to meet its obligations, and in general that the global capital system faces collapse.
That has frozen the credit markets and kept investors from focusing on what market mavens like to call the fundamentals -- the capital strength, management quality and business prospects of individual companies.
Instead, hedge funds receiving redemption orders from clients are dumping everything in their portfolios. Retirees and parents with children approaching college age are selling out now, unwilling to bear the risk that their net worth will shrink even further if they wait.
“A huge amount of money is leaving the equity markets because people need cash,” Karabell said, “not because they’re making cogent decisions about companies.”
He points to shares of drug company Pfizer Inc., down 33% from their 52-week peak even though the company holds $20 billion in cash and offers a nearly 7% dividend yield. “It’s irrational.”
Veteran market observers say that expectations of Armageddon are not unusual during bear markets, in which stock prices decline by 20% or more.
“Every bear market has been caused by something so different from the last one that each looks like the end of the world,” said Vince Farrell, chief investment officer of the research firm Soleil Securities Group. “In a bear market, sentiment is always horrific.”
But he notes that many bear markets of the past were worse than this one (so far). The 2000-02 and 1973-74 bear markets each sliced more than 45% off share values. Worse, the latter was triggered by the Arab oil embargo.
“That time the solution was out of our control. The solution this time is in our control,” he said, citing the government’s dramatic rescue efforts.
Still, there’s no doubt that today’s stock market is weighed down by genuine economic woes. The U.S. and its trading partners are entering or are already mired in a recession. Housing prices continue to slide and statistics show that consumers are reducing spending, which may stifle growth well into 2009.
The sober International Monetary Fund, in its semiannual World Economic Outlook, released Wednesday, observed that the globe was “entering a major downturn in the face of the most dangerous financial shock” since the 1930s.
Many investment managers believe that the government initiatives thus far are aimed at the wrong target.
“This is a fool’s errand,” said Bill Fleckenstein, president of Seattle-based Fleckenstein Capital and a long-term bear, who has bet on declining stock prices.
“The market could have a big rally, sure, but is this like 1987, where it keeps going up for a couple of years? No. The economic contraction staring us in the face could be pretty vicious, and the government ought to start thinking about how to address unemployment by fixing all our roads, bridges and ports instead of trying to dictate house prices and stock prices.”
Moreover, the market can be greatly influenced by negative forecasts. TV host and stock trader Jim Cramer said this week that a drop in the Dow to 7,700 -- a plunge of 1,558 points, or 17%, from Wednesday’s close -- is “a very real possibility.”
He has been urging small investors to bail out of the market if their investment horizons are shorter than five years. Such exhortations are likely to be contributing to the sell-off that has led to the Dow index falling for a sixth straight day Wednesday, with a cumulative loss of 15%.
Even so, the link between stock prices and economic expectations doesn’t resemble super-glue as much as a bungee cord. History teems with bad market calls, many of which seemed unimpeachable at the time.
Consider Business Week’s cover story on Aug. 13, 1979, which proclaimed “The Death of Equities.” Inflation was rolling at 6.5% a year, equity returns were half that, and money market fund yields in the mid-teens had drawn billions of dollars out of the stock market, prompting the magazine to label Americans’ aversion to stocks “a near permanent condition.”
“We have entered a new financial age,” a business professor told the magazine. “The old rules no longer apply.”
One year later, the Dow had gained 8.5% and within 10 years it had tripled. Appearing just at the onset of a 20-year bull market, “The Death of Equities” ranks as one of the market’s most famous wrong calls, perhaps second only to economist Irving Fisher’s judgment that “stock prices have reached what looks like a permanently high plateau” -- words he uttered on Oct. 21, 1929, three days before the onset of the great crash.
Similar misjudgments can occur at market tops. On the heels of the peak a year ago, Business Week weighed in with the judgment that “the global economic boom” might carry the Dow all the way to 16,000 over the following six to 12 months.
What might turn market sentiment around this time? The record suggests that at times of violent fear or euphoria like the present, it doesn’t take much.
In August 1982, for example, the Dow index was bumping along at a more than two-year low. The country was in the clammy grip of recession, with unemployment at 10% and business failures reaching heights not seen since the Depression. The prime rate hovered around 15%. Expectations were that the seemingly unruffled Ronald Reagan would be a one-term president.
Then, on Aug. 17, Henry Kaufman, the Salomon Bros. economist who had earned the nickname “Dr. Doom” for his mercilessly gloomy forecasts of higher interest rates, suddenly announced that he saw sharply lower rates on the horizon. The Dow gained nearly 5% that day (a then-record 38.81 points). In the year following Dr. Doom’s epiphany, it rose 52%.
Of course, none of that can give today’s investors any clue to what may happen in the markets this time around. A reversal could begin today, next week, after New Year’s Day or never. The next rally could be the start of something big or merely a head fake.
“I don’t see the next bull market,” Farrell said. “But you never see it because the news is so unrelentingly bad.”
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